Economic relations in the euro zone amount to a game of chicken. Like car drivers aiming directly at one another, governments are challenging their counterparts to flinch first and give in. Unfortunately, the economic study of strategic behavior — also known as game theory — suggests that if you play chicken too many times, you will eventually crash the proverbial car.

Few months back I did a post Italy was in strong position according to the game theory titled The Euro Crisis : Italy in strong position

There is continuing deal-making between the more solvent countries, like Germany, the Netherlands and Finland, and the more financially troubled countries, most prominently Greece, Portugal and Spain. The sounder countries aid the fiscally troubled ones, but also try to control those nations’ spending, if only to limit potential future exposure through additional bailouts. Countries on both sides are seeking more favorable terms from these negotiations, which are often conducted through intermediate institutions like the European Central Bank and various bailout funds.

In such a setting, the euro zone’s mess could last for a long time, with neither solution nor dissolution.

When matters appear to improve, or when the troubled countries receive more aid, there is more slack in the system. The troubled countries respond by behaving less responsibly and, as a result, move the financial situation closer to the precipice again. For instance, when the European Central Bank announced its debt monetization plans, Spain’s government suddenly faced lower borrowing rates and then refused to apply for a politically costly bailout and austerity package.

When matters become worse, the fiscally healthier countries pony up more aid, as we have seen them do repeatedly for Greece.

It is thus a mistake to overreact to most of the headline events about the euro zone crisis. The good news is never quite as good as it looks, and the bad news often brings beneficial responses. It seems that for dozens of months now, we’ve been hearing that the fate of the euro zone will be decided “shortly,” yet somehow the drama continues.

The mess won’t be resolved until the various governments raise their hands and announce transparently just how much of the mess they will pay for — and how. Such announcements will then need to be validated by elections. That means sending a consistent message to other countries and to their own domestic electorates and interest groups. Until then, the game of chicken will continue, and the risks of financial catastrophe will remain high.

Source : Extract from NY times

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